False Start: Why Newly Formed Online Businesses Should be Cautious When Deducting Business Expenses

Published: Sep 26, 2024
By: Connor E. McGettigan
Topics: Tax
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Under IRC Sec. 162, taxpayers are allowed to deduct expenses related to the carrying on of a trade or business, provided the expenses are both ordinary and necessary. However, not all expenses qualify for the trade or business expense deduction. Often, taxpayers get into hot water by deducting expenses related to the business’s formation under IRC Sec. 162 when they are not qualified. With recent increases to IRS audit funding, many businesses are facing examinations and reassessments of deductions improperly claimed under IRC Sec. 162, significantly impacting their tax liabilities.

What is a “business expense” under IRC Sec. 162?

Since its inclusion in the Code, Sec. 162 has been subject to significant debate -- particularly the definitions of “ordinary” and “necessary.” In fact, whether expenses are deductible under IRC Sec. 162 continues to be the most litigated issue in Tax Court by U.S. business taxpayers. Through this controversy, courts have deemed expenses “ordinary” when they are considered “normal, usual or customary,” and “necessary” when they are considered “appropriate and helpful” for the development of a business. Understanding when a business can begin taking deductions under IRC Sec. 162 can be equally as important as whether the expense is deductible at all.

IRC Sec. 195 Deduction for Start-Up Expenditures

While taxpayers can generally deduct a trade or business expense in the year the expense occurred, special rules apply to the deductibility of start-up expenditures under IRC Sec. 195. Start-up expenditures are defined under IRC Sec. 195(c) as those incurred in the “investigation, creation, or anticipation of a trade or business.” IRC Sec. 195 currently limits the deduction for start-up expenditures to a maximum deduction of $5,000, with excess expenditures capitalized and amortized over the ensuing five years. Start-up expenditures generally include any amount that would otherwise be deductible under IRC Sec. 162, but which are incurred prior to the business opening.

Historically, when a trade or business begins has depended largely on when it starts the operations for which it was organized. In most cases, this has been understood to mean opening the business up to the public in pursuit of profit. However, some businesses have successfully argued that their operations started sooner, enabling taxpayers to receive an immediate tax benefit under IRC Sec. 162. In the case of U.S. v. Manor Care, Inc., a taxpayer successfully argued its expenses were deductible under IRC Sec. 162 due to the certainty of the business opening.

Business Expense Exams

Despite the Treasury Department having authority to establish regulations to determine when a trade or business begins, such regulations have never been drafted. Instead, examiners employ a facts and circumstances analysis to decide when a trade or business officially begins. Because the review is fact and time intensive, IRS examiners may be quick to recharacterize business expenses deducted under IRC Sec. 162 by a newly formed business as IRC Sec. 195 start-up expenditures. To avoid this, taxpayers are encouraged to keep documentation of expenses incurred near the time of starting business operations to assist in arguing for current-year treatment. Not only is recordkeeping required under Treas. Reg. 1.446-1(a)(4), doing so reduces the probability of examiners denying deductions under both Sec. 162 and 195.

The nature of a particular expense often demonstrates whether the expense should be treated as start-up expense under Sec. 195 or as ordinary and necessary under Sec. 162. Expenses related to lease deposits, consultant expenses, and feasibility studies commonly indicate to examiners that the business has yet to start-up and favors Sec. 195 treatment. Meanwhile, expenses related to employee wages, travel, and advertising could fall under Sec. 162 or Sec. 195, depending on the business purpose. Examiners often require additional substantiation to not only prove the expense was incurred and paid, but to also determine treatment under the Code. Because the burden is on the taxpayer to substantiate their expenses, keeping records and receipts is essential to ensure proper treatment under the Code.

Online Businesses

As online shopping and programing continue to grow, historical tests used by courts to determine when a business begins for purposes of Sec. 162 are facing renewed challenges. In Kellett v. Commissioner, the taxpayer, an online retail website, did not generate income in the first four years its website was active but took deductions under Sec. 162. The taxpayer argued that the business needed to grow its presence before generating income. Using revenue generated as its litmus test, the IRS attempted to capitalize, under Sec. 195, the expenses the taxpayer currently deducted under Sec. 162. Ultimately, the Tax Court ruled in favor of the taxpayer and found that a taxpayer’s attempt to sell a good or service better demonstrates the current operation of a trade or business than does revenue generation.

Although the decision in Kellett was taxpayer friendly, it was largely predicated on the fact that the taxpayer’s online business was novel, with no other similar businesses operating online at the time. This signals that courts are likely to continue applying a more traditional approach to online business start-ups seeking to enter an already established market. While courts may be more sympathetic to taxpayers with online businesses than previously anticipated, these same taxpayers should ensure that their expenses are related to growing the business itself. Merely marketing a product is not enough to take advantage of Sec. 162 and avoid IRS scrutiny. As always, diligent record keeping is essential in case an online business’s deductions are challenged.

The growth of online business presents new challenges for taxpayers and practitioners in determining whether and when business expenses are deductible under Sec. 162. While an expense may be both “ordinary” and “necessary,” additional factors the business faces, independent of the expense, could be enough to recharacterize how that expense is treated on the business’s return. With an increase in IRS funding available for examinations, taxpayers should be prudent in documenting and properly characterizing the expenses associated with a newly formed business.